Korea’s Tax System: A Growth- Oriented Choice
Joosung Jun
Initiative for Policy Dialogue Working Paper Series, 2009
Over the past several de cades, Korea’s tax policy has focused on protecting the revenue base to fi nance economic growth, in the face of significant enforcement problems. With a nonnegligible size of the informal sector and a weak bookkeeping culture, the government had to focus on a small number of large corporations in collecting revenue. A wide range of tax and nontax subsidies were provided to protect businesses from disappearing into the informal sector. Many of the tax incentives in place might have been more effective in mitigating enforcement problems than in promoting the targeted activities.
To the extent that this base-protection eff ect has been signifi can’t, the revenue and effi ciency costs associated with these tax preferences in most tax debates appear to be overstated. Statutory loopholes and lenient enforcement, which have been criticized as sources of ineffi ciency and tax evasion, often refl ect a rational response by the government caught between evasion pressures and base- broadening needs. The proportional taxation of capital income and the simplified scheme for taxation of the self-employed are representative cases in point. The government has also had to adopt some unconventional means of raising revenue, such as earmarked taxes and surcharges.
All of these factors have made the tax revenue structure in Korea quite diff erent from what is observed in developed countries. The personal income tax is of relatively minor importance in Korea, and the bases for the corporate and VAT are quite narrow. Earmarked taxes and property transaction taxes both account for signifi can’t shares of total tax revenue. Unless these underlying factors change greatly, a drastic reshaping of the tax structure is unlikely to be either feasible or desirable. A shift to the more conventional tax policies observed among developed countries could possibly generate more revenue and effi ciency costs than theories suggest.
The financial crisis in Korea provides an interesting case study of how tax design can be affected by a change in the economic structure. In the aftermath of the crisis, the Korean corporate and financial sectors underwent drastic restructuring, and the economy was made more open. These structural changes led to a lower- leveraged capital structure for most corporations and a more open and better- functioning financial sector. To the extent that businesses come to receive more benefi ts from using the fi nancial sector, the relative size of the informal sector will shrink. Indeed, the base for the VAT, the most important source of revenue, appears to have been improving in the years since the crisis. The long- run revenue implications of these changes are inconclusive, however. A reduction in debt financing may lead to declines in new investment and production. In addition, an increase in capital mobility will lead to more opportunities for tax avoidance.
Considering the potential costs of reunification and the soaring welfare expenditures stemming from the rapid aging of the Korean population and the maturing of public pensions, the top priority for taxation is to expand the revenue base in an efficient and equitable manner. For base- broadening purposes, conventional prescriptions include the elimination of “unnecessary” deductions and exemptions in the personal income, corporate income, and VAT systems.69 Reducing the scope of earmarked and transaction taxes is also a favorite menu item, with various ineffi ciencies associated with these taxes being cited. As emphasized in this chapter, however, some of these instruments play a role in protecting the tax base from erosion into the informal sector, and this off sets their revenue and efficiency costs. Probably a more useful and urgent task is to create an environment in which tax information is more readily available. Further reform of the financial sector as well as more effi cient sharing of information among government agencies will be a step in the right direction. Financial incentives for compliance and administrative changes toward self- assessment will also likely be more effective when taxpayers find it useful to remain in the formal sector.
Korea’s Tax System: A Growth- Oriented Choice
Joosung Jun
Initiative for Policy Dialogue Working Paper Series, 2009
Over the past several de cades, Korea’s tax policy has focused on protecting the revenue base to fi nance economic growth, in the face of significant enforcement problems. With a nonnegligible size of the informal sector and a weak bookkeeping culture, the government had to focus on a small number of large corporations in collecting revenue. A wide range of tax and nontax subsidies were provided to protect businesses from disappearing into the informal sector. Many of the tax incentives in place might have been more effective in mitigating enforcement problems than in promoting the targeted activities.
To the extent that this base-protection eff ect has been signifi can’t, the revenue and effi ciency costs associated with these tax preferences in most tax debates appear to be overstated. Statutory loopholes and lenient enforcement, which have been criticized as sources of ineffi ciency and tax evasion, often refl ect a rational response by the government caught between evasion pressures and base- broadening needs. The proportional taxation of capital income and the simplified scheme for taxation of the self-employed are representative cases in point. The government has also had to adopt some unconventional means of raising revenue, such as earmarked taxes and surcharges.
All of these factors have made the tax revenue structure in Korea quite diff erent from what is observed in developed countries. The personal income tax is of relatively minor importance in Korea, and the bases for the corporate and VAT are quite narrow. Earmarked taxes and property transaction taxes both account for signifi can’t shares of total tax revenue. Unless these underlying factors change greatly, a drastic reshaping of the tax structure is unlikely to be either feasible or desirable. A shift to the more conventional tax policies observed among developed countries could possibly generate more revenue and effi ciency costs than theories suggest.
The financial crisis in Korea provides an interesting case study of how tax design can be affected by a change in the economic structure. In the aftermath of the crisis, the Korean corporate and financial sectors underwent drastic restructuring, and the economy was made more open. These structural changes led to a lower- leveraged capital structure for most corporations and a more open and better- functioning financial sector. To the extent that businesses come to receive more benefi ts from using the fi nancial sector, the relative size of the informal sector will shrink. Indeed, the base for the VAT, the most important source of revenue, appears to have been improving in the years since the crisis. The long- run revenue implications of these changes are inconclusive, however. A reduction in debt financing may lead to declines in new investment and production. In addition, an increase in capital mobility will lead to more opportunities for tax avoidance.
Considering the potential costs of reunification and the soaring welfare expenditures stemming from the rapid aging of the Korean population and the maturing of public pensions, the top priority for taxation is to expand the revenue base in an efficient and equitable manner. For base- broadening purposes, conventional prescriptions include the elimination of “unnecessary” deductions and exemptions in the personal income, corporate income, and VAT systems.69 Reducing the scope of earmarked and transaction taxes is also a favorite menu item, with various ineffi ciencies associated with these taxes being cited. As emphasized in this chapter, however, some of these instruments play a role in protecting the tax base from erosion into the informal sector, and this off sets their revenue and efficiency costs. Probably a more useful and urgent task is to create an environment in which tax information is more readily available. Further reform of the financial sector as well as more effi cient sharing of information among government agencies will be a step in the right direction. Financial incentives for compliance and administrative changes toward self- assessment will also likely be more effective when taxpayers find it useful to remain in the formal sector.